INTRODUCTORY TO MACROECONOMICS

FINAL-TERM REVIEW

Problem 1: Open-Economy Macroeconomics: Basic Concepts

A can of soda costs $1.25 in the United States and 25 pesos in Mexico. What is the peso–dollar exchange
rate (measured in pesos per dollar) if purchasing-power parity holds? If a monetary expansion caused all
prices in Mexico to double, so that soda rose to 50 pesos, what would happen to the peso–dollar exchange
rates?

If purchasing-power parity holds, then 25 pesos per soda divided by $1.25 per soda equals
the exchange rate of 20 pesos per dollar. If prices in Mexico doubled, the exchange rate will
double to 40 pesos per dollar.

Problem 2: A Macroeconomic Theory of the Open Economy

Suppose that real interest rates increase in the United States. Explain how this development will affect
Indonesia net capital outflow. Then explain how it will affect Indonesia net exports by using a formula from
the chapter and by drawing a diagram. What will happen to the Indonesia real interest rate and real exchange
rate?

Higher real interest rates in U.S. lead to increased Indonesia net capital outflow. Higher net capital outflow
leads to higher net exports, because in equilibrium net exports equal net capital outflow (NX = NCO). Figure
8 shows that the increase in net capital outflow leads to a lower real exchange rate, higher real interest rate,
and increased net exports.

Figure 8
Problem 3: Aggregate Demand and Aggregate Supply

Suppose firms become very optimistic about future business conditions and invest heavily in new capital equipment.
a. Draw an aggregate-demand/ aggregate-supply diagram to show the short-run effect of this optimism on the
economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output
supplied changes.

a. If firms become optimistic about future business conditions and increase investment, the result is shown in
Figure 17. The economy begins at point A with aggregate-demand curve AD1 and short-run aggregate-supply
curve AS1. The equilibrium has price level P1 and output level Y1. Increased optimism leads to greater
investment, so the aggregate-demand curve shifts to AD2. Now the economy is at point B, with price level P2
and output level Y2. The aggregate quantity of output supplied rises because the price level has risen and
people have misperceptions about the price level, wages are sticky, or prices are sticky, all of which cause
output supplied to increase.

Figure 17
b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For now,
assume there is no change in the long-run aggregate-supply curve.) Explain in words why the
aggregate quantity of output demanded changes between the short run and the long run.

b. Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust, the
short-run aggregate-supply curve shifts to the left to AS2 and the economy gets to equilibrium at
point C, with price level P3 and output level Y1. The quantity of output demanded declines as the price
level rises.

c. How might the investment boom affect the long-run aggregate-supply curve? Explain.

c. The investment boom might increase the long-run aggregate-supply curve because higher
investment today means a larger capital stock in the future, thus higher productivity and output.
Problem 4: The Infulence of Monetary and Fiscal Policy on Aggregate Demand
Suppose that survey measures of consumer confidence indicate a wave of pessimism is
sweeping the country. If policymakers do nothing, what will happen to aggregate demand?
What should Bank Indonesia do if it wants to stabilize aggregate demand? If Bank Indonesia
does nothing, what might Congress do to stabilize aggregate demand?

If pessimism sweeps the country, households reduce consumption spending and firms reduce
investment, so aggregate demand falls. If Bank Indonesia wants to stabilize aggregate
demand, it must increase the money supply, reducing the interest rate, which will induce
households to save less and spend more and will encourage firms to invest more, both of
which will increase aggregate demand. If Bank Indonesia does not increase the money supply,
Congress could increase government purchases or reduce taxes to increase aggregate
demand.
Problem 5: The Short-Run Trade-off between Inflation and Unemployment
Suppose that a fall in consumer spending causes a recession.
a. Illustrate the immediate change in the economy using both an aggregate-supply/ aggregate- demand
diagram and a Phillips-curve diagram. On both graphs, label the initial long-run equilibrium as point
A and the resulting short-run equilibrium as point B. What happens to inflation and unemployment
in the short run?

Figure 13

a. Figure 13 shows how a reduction in consumer spending causes a recession in both an aggregate-
supply/aggregate-demand diagram and a Phillips-curve diagram. In both diagrams, the economy
begins at full employment at point A. The decline in consumer spending reduces aggregate demand,
shifting the aggregate-demand curve to the left from AD1 to AD2. The economy initially remains on
the short-run aggregate-supply curve AS1, so the new equilibrium occurs at point B. The movement
of the aggregate-demand curve along the short-run aggregate-supply curve leads to a movement
along short-run Phillips curve SRPC1, from point A to point B. The lower price level in the aggregate-
supply/ aggregate-demand diagram corresponds to the lower inflation rate in the Phillips-curve
diagram. The lower level of output in the aggregate-supply/ aggregate-demand diagram corresponds
to the higher unemployment rate in the Phillips-curve diagram.
 b. Now suppose that over time expected inflation changes in the same direction that actual inflation
changes. What happens to the position of the short-run Phillips curve? After the recession is over,
does the economy face a better or worse set of inflation–unemployment combinations? Explain.

b. As expected inflation falls over time, the short-run aggregate-supply curve shifts to the right from AS1
to AS2, and the short-run Phillips curve shifts to the left from SRPC1 to SRPC2. In both diagrams, the
economy eventually gets to point C, which is back on the long-run aggregate-supply curve and long-
run Phillips curve. After the recession is over, the economy faces a better set of inflation-
unemployment combinations.

https://www.youtube.com/watch?v=2FeugaLv5Bo&t=6s